Emerging market equities have a strong chance of being one of the major investment stories of the next 10 years thanks to a mixture of five powerful tailwinds. 
That’s the view of Richard Titherington (pictured), chief investment officer and head of the emerging markets and Asia Pacific equities team at JP Morgan Asset Management, who thinks that maintaining an underweight to the asset class makes much less sense today than it did back in 2011.
Emerging markets have endured a bout of persistent underperformance as investor flocked to relatively ‘safer’ areas of the market in the wake of the global financial crisis, including developed market stocks and government bonds.
As the below chart shows, the MSCI Emerging Markets index posted a loss of close to 17 per cent between the start of 2011 and the end of 2015. Over the same period, the developed market-focused MSCI World index was up more than 50 per cent thanks to bullish investor sentiment and ultra-loose monetary policy.
Performance indices between 2011 and 2015
Source: FE Analytics
But Titherington does not think this dynamic is set to continue over the coming decade.
“Whereas developed market equities over the last 10 years richly rewarded investors with average annualised returns in excess of 7 per cent, the future outlook is much grimmer with average returns over the next 30 years – in a slow growth environment – expected to drop below 5 per cent, according to JPMAM research,” he said.
“And yet, investors remain sceptical of emerging market equities, even when the cyclical asset class is showing signs of economic strength and global activity is rebounding. As the structural story in emerging markets continues to evolve and opportunities open up, investors may therefore be missing a trick by maintaining an underweight to the asset class.”
Indeed, emerging market equities have been stronger in the more recent past. The MSCI Emerging Markets index made a 45.77 per cent total return between the start of 2016 and 17 April 2017, outperforming MSCI World’s 33.40 per cent by a decent margin.
While an emerging market chief investment officer might be expected to see the positives in their own asset class, Titherington highlights five specific reasons why emerging markets could start to outperform.
Firstly, the reflation trend that many investors have their eye on is positive for emerging markets. While they have been concerned by the threat of deflation since the financial crisis, many investors are now expecting a reflationary period with relatively stronger growth and inflation numbers have started to pick up across the globe.
“Emerging economies and corporate earnings hit a cyclical low in early 2016 and a synchronized recovery in global growth currently offers a supportive backdrop,” Titherington said. “While we expect Chinese growth to moderate from here, the risks from US protectionism are more contained than initially feared.”
Performance of indices between 1 Jan 2016 and 17 April 2017
Source: FE Analytics
Secondly, the CIO argues that emerging market equities are now better placed to deal with a strong US dollar, which has historically been a negative for the asset class. This is down to factors such as global sensitivity to the dollar and the number of emerging market countries requiring foreign capital being at their lowest for some time.
“As we enter the last phase of the US dollar bull cycle there will almost certainly be some headwinds for emerging markets (which will most likely manifest in some currency pressure) but we believe we are in the final innings and are positioning ourselves accordingly for when the US dollar tops out. Currency risk is behind us, not in front of us,” he said.
Next, the MSCI Emerging Markets index has “changed dramatically” over the past five years and presents a much better opportunity set for the emerging market investor.
“Structural growth sectors now dominate the index as commodities have become eclipsed by the financials, consumer and IT sectors (IT is now 23 per cent of the index up from 12 per cent in 2007),” Titherington explained.
“The index has experienced a shift away from low return on equity [ROE], higher leverage, excess capacity industries towards higher ROE, lower leverage, new-economy industries. Today’s universe is about domestic growth in sectors like e-commerce and insurance.”
The CIO also points out that earnings are “turning a corner” in emerging markets. While earnings had contracted for four years in a row, last year they grew by 10 per cent in dollar terms and analysts expect growth of 13 per cent in 2017. However, he adds that earnings upgrades have been concentrated in the materials and IT sectors, so this now needs to broaden out to other sectors.
Finally, Titherington highlights a sector-specific factor that could offer opportunities for emerging market investors – fin tech. He is especially positive on financial companies that were established in the last 15 to 20 years that do not have to manage cumbersome legacy systems.
“We like a number of Indian financials which are successfully managing to penetrate rural India with lower cost technology,” he added. “There are numerous examples of high quality businesses able to offer compounded earnings growth, higher ROE and lower debt.”